Enterprise-grade payments for permissioned blockchains

Earlier in the week startup Stronghold announced another dollar-pegged token. Some in the enterprise world equate these ‘stablecoins’ with cryptocurrencies and aren’t interested. This leads to the question: what would be palatable for enterprises?

The need for an enterprise-grade settlement token

One of the oft-touted benefits of blockchain payments is speed. But in many economies, you can make instant domestic bank payments. The real advantage is the speed of the entire transaction process.

A typical sequence with conventional transactions is to agree to a deal, wait for payment, then deliver. If the payment part isn’t on a blockchain, sometimes the transaction needs to wait until the payment confirmation. That eats into the benefits of automation.

But if the settlement uses a token to represent a bank balance, then the entire transaction completes in almost real-time. Techies call this an atomic transaction. It’s all or nothing, no payment no transaction.

This quick settlement advantage described so far could apply to any cryptocurrency, though that’s not the topic here. Most enterprises have little appetite for the risk and volatility involved with cryptocurrencies.

For enterprises, there’s another, sometimes more important benefit. Each part of the transaction involves a reconciliation process. Having it all on a blockchain means the entire process is both shared and reconciled. An automation dream.

While companies can cope with foreign currencies, accounting systems usually have a default currency used for reporting. So to match up invoices and payments, it’s better to have them in the same currency. Bitcoin hasn’t taken off as a ‘unit of account’ so there aren’t many companies denominating their sales in Bitcoin. Hence tokens for US Dollars, Euros and other major currencies ‘fit the bill’ nicely.

Central Bank Currencies

Central Bank Digital Currencies (CBDC) aren’t likely to arrive any time soon, unless you count the likes of Venezuela. Both the UK and Sweden have explored them, but they’re deemed too risky for now. It all comes down to what happens when there’s a loss of confidence.

What if you had the right to convert your bank balance into central bank tokens? If a bank had a crisis, customers would quickly switch deposits into central bank tokens, breaking the speed record for bank runs.

It also results in the central bank likely becoming the biggest bank. That’s a lot of concentration of risk.

The Bank of England started exploring the topic in 2016 and recently published a report that examines various workarounds.

There’s even a startup, Basis, that calls itself a stable cryptocurrency with an algorithmic central bank. It hasn’t yet launched and recently raised $133m in venture capital from Bain, Google Ventures, Stanley Druckenmiller and many others.

Basis’ founders have backgrounds in quantitative finance and algorithmic trading. Their plans involve managing the money supply in a not-dissimilar way to a central bank, but automated. Basis certainly is far closer to Satoshi Nakomoto’s vision than deposit-backed stablecoins. The Basis whitepaper is interesting but raises many questions.

The BIS view

The Bank of International Settlements (BIS), the bank for central banks, recently wrote about the topic. They too concluded a CBDC was too risky. However, the BIS commented that it was worth exploring CBDCs for wholesale transactions amongst financial institutions such as the Canadian Project Jasper.

On the whole the BIS concluded, some would say predictably, that “cryptocurrencies do not work as money”.

However, the BIS was far more optimistic about what it referred to as “cryptopayments” where the unit of account is a sovereign currency. “The underlying technology can be adopted by registered exchanges in permissioned protocols that use sovereign money as backing, simplifying settlement execution… Crucially, however, none of the applications require the use or creation of a cryptocurrency.”

So there’s a possibility that cryptopayments or settlement tokens in a permissioned environment might get a blessing.

Before looking at bank solutions, it’s worth exploring some of the existing initiatives.

Tether

The Dollar-linked token idea isn’t new, and Tether has been running a cash-backed dollar token for a few years, though it’s growth accelerated in December last year. Cryptocurrency traders primarily use the token and currently it has a daily turnover of $2bn to $4bn with a market capitalization of $2.7bn.

Cryptocurrency traders struggle with bank accounts, so tether is a convenient surrogate. Plus if traders want to sit out a cryptocurrency downswing, Tether is an option. The main reason for the popularity with traders is the lack of suitable alternatives. Convenience trumps all. However, the token is shrouded in controversy.

Tether's gray areas

Tether’s gray areas

Tether is closely associated with exchange Bitfinex, and the U.S. Commodity Futures Trading Commission subpoenaed both Tether and Bitfinex. Bitfinex was hacked back in 2016 and allegedly ‘socialized’ the loss. There are allegations that Tether is used for wash trading which means the buyer is also the seller in the same transaction to inflate volumes.

Most of all, the audit of the bank accounts that hold the underlying currency is a gray area. They parted company with Friedman LLP who were requested to analyze but not audit the bank balances.

They then engaged a respected law firm which confirmed $2.5bn in bank accounts at June 1st. It appears the engagement was to verify the balances on a single day, though the lawyers chose the day without notice (good). One of the law firm’s partners is on the advisory board of one of Tether’s banks which wasn’t deemed a conflict.

While the law firm has a specialism in due diligence, why choose a law firm rather than an auditor?

So your average enterprise may not be comfortable in using Tether for transactions.

Stronghold

Earlier this week Stronghold announced its USD backed currency on the Stellar network targeted at enterprises. They’re doing a lot right.

They have venture backing, and the company switched its base to New Zealand to get a license. They engaged a US regulated, state-chartered trust company to manage their reserves. And IBM announced it would be experimenting with the settlement token.

So now will enterprises take the risk?

Trust and risk

On the one hand, we have Bitcoin which is theoretically trustless. Yet Nick Szabo, the inventor of the smart contract concept, said: “There is no such thing as a fully trustless institution or technology.” So for Bitcoin you’re trusting that the three mining pool operators that control 50% of the mining will behave appropriately.

Who do you need to trust with Stronghold?

Stronghold due diligence questions

If performing due diligence on Stronghold, the questions might include:

Who is the Stronghold management team and do we trust them?

Who is the trust company and do we trust them to look after the money?

Is the trust company sufficiently independent from Stronghold?

How will the custodian process work?

At what level are they trustworthy? 100m, 100billion, a trillion?

If there are thousands of bank accounts how practical is it to audit them?

Do we trust the programmer involved in demonstrating the account transparency?

The New Zealand license is for their trading platform. Does that cover Stronghold USD?

How do jurisdictions work if the token holder is in the US, EU or elsewhere?

The FDIC question

Several reports stated that Stronghold is FDIC covered by splitting the money into multiple bank accounts. FDIC insurance is only for US deposits up to $250,000. Enterprises don’t expect full FDIC coverage and tend to have a few bank accounts.

The FDIC coverage concept doesn’t scale. Volumes similar to Tether’s $2.5 billion would need accounts at 10,000 separate banks. In 2017 the FDIC only insured 5,670 institutions. And with thousands of bank accounts, the complexity of the audit process might reduce confidence in the custodial oversight. So you create a different trust problem.

While Stronghold has made a good start, for now they may fall short on some of these questions from the perspective of enterprises. For starters, the trust company that’s acting as custodian is a two-year-old startup. Enterprises might be happier with a well-known custodian like State Street (custodian for $33.3 trillion) or BNY Mellon (custodian for $31.6 trillion). Or a big four accountant.

That said, Stronghold USD may be far more appealing than Tether. It could appeal for use cases that don’t need a huge scale. And some enterprises might want to start using tokens at low volumes while they await a better alternative.

Aryze

Aryze, an early-stage Danish startup, has plans for stablecoins that are more conservative compared to Stronghold.

Co-founder Morten Nielsen has previously worked with JP Morgan and UBS. Nielsen raised the FDIC issue saying that stablecoins “might not be covered by local government backing of private deposits. In other words, if you don’t have that as part of your system, then you have significant risk if that bank goes down.”

However, if you invest in government securities, then you have government backing. Their models show that likely only 20-25% of funds need to be in a bank account and they plan to put the balance in government securities. But government securities are not entirely stable and could break the one-to-one matching. Hence they intend to mainly invest in less volatile short-term securities and over-collateralize by 2.5% or more.

A conservative approach

A conservative approach

Asked about whether banks could solve the issue between them, Nielsen disagreed. “For me, this is definitely a fintech job to create that global infrastructure. So what we need to do is provide a risk management model that makes this completely in line with not just want banks do, but an even better risk management solution than what they have.”

Nielsen elaborated: “There will be no human interaction in the risk-taking on our part. We’ll take a little bit of yield curve risk, but that would be managed completely through risk management models.”

“We’re building our business case from the perspective that if Aryze goes down or doesn’t fulfill it’s management obligations, our advisers can take over control of the whole system. Our advisers would be the biggest consultancy houses in the world.”

They’ve also considered what might happen in bad times. Government securities will back any stablecoin they issue for that currency. “You never had a situation where a central bank will default in their own currency. They would just issue more money.”

In the case of a bank run, there could be high demand to switch into Aryze stablecoins, so there will be limits on how many tokens can be bought at any time. Also if a central bank issues an instruction to stop transactions between two currencies, they would comply. So they plan to have limits.

In the worst case scenario if there was a single bank account for one currency and that bank folded, then Aryze could lose the 20% deposit.

It was hard to find holes in Nielsen’s thinking, though given their early stage, it’s the execution that matters. It’s likely to be at least a year or more before they go live.

Scale

When you start to think of the trillions involved in equities trading or supply chains, the figures are immense. Tether’s $2.5bn, while impressive, is minuscule by comparison. Ignoring risk and trust issues for a moment, is it conceivable that something like a Tether or a Stronghold USD or Aryze could grab a substantial slice of global trade? That would certainly be a systemic risk.

In fact, it would be a risk for any single bank. So what about a group of banks?

R3 and banks

If considering banks collaborating on a token, then enterprise blockchain company R3 is the one to ask, with the majority of its over 40 shareholders involved in financial services.

Todd McDonald, R3’s co-founder confirmed the rationale. “To be really impactful outside of internal use cases, it’s not going to be a single bank issuing liquidity. It will either be a consortium or network of banks, perhaps in a special purpose vehicle created on behalf of a group, that very importantly is recognized by the regulatory community and the central bank community.”

But there’s a drawback for banks. Startups think about opportunities whereas incumbents consider opportunity costs. You might think that you pay for tokens with real money, so it’s just your money the bank holds. But the bank doesn’t know in advance what the demand might be, so they have to commit a block of funds to tokens.

McDonald elaborated: “If you have to pre-fund a vehicle that issues liquidity, that costs money. That’s a business case challenge.”

“But if you can leverage assets already held in custody, you can create liquidity on-chain that both lowers cost and potentially increased revenue. That’s the interesting angle for banks, market infrastructure providers, and asset managers.”

The banks have the advantage of being regulated institutions. But while they may not need new licenses, the compliance issue is immense. And the legal aspects are somewhat important for these atomic transactions which involve both delivery and payment. You need certainty of payment finality. As McDonald put it, “when there’s any doubt whether the payment is legally binding or regulatory compliant, that doesn’t do anyone any good.”

Final thoughts

Enterprises have a choice not to have on-chain payments, or to use APIs. For on-chain payments, the only options currently available are stablecoins. As those evolve to be more conservative, they could be quite palatable for enterprises.

Bank consortia are likely to provide an option. Initially, they’re likely to target demand from financial institutions and corporates. But they’d better get a move on. Once stablecoins gain traction outside of the crypto trader world, they could be hard to dislodge.